Question

1.      What could cause a previously upward-sloping yield curve to flatten out and eventually become downward sloping?

2.      “An increase in government spending financed by borrowing from the public will increase the supply of money.” Comment on this statement.

3.      Assume the government finances a spending increase by issuing new securities. Does this create a burden on future generations? Why or why not? Would it make a difference whether the spending increase was used to finance the building of a new highway or to send troops abroad to fight a war in another country?

4.      Explain how the sharp decline in housing values contributed to the financial crisis that started in 2008.

5.      In the early 1930s, interest rates were extremely low and money supply fell sharply. Does this indicate that the Fed used expansionary or restrictive monetary policy? Explain your answer.

6.      Do you think the Keynsian or the monetarist view provides a better explanation of the causes of the Great Depression? Why?

7.      Comment on the following statement:

         “A balance of payments surplus may lead to inflation, while a balance of payments deficit may lead to unemployment.”

8.      Comment on the following statement:

         “A trade imbalance can persist as long as the central bank wants it to.”

9.      In the early 1980s, the U.S. trade deficit increased sharply, yet at the same time the value of the U.S. dollar increased steadily. How can this be explained?

10.    Comment on the following statement:

         “If a central bank used expansionary monetary policy to lower the value of the domestic currency, the country’s trade imbalance would immediately improve.”

11.    Assume interest rates in the U.S. are currently 5% and you expect the Japanese yen to appreciate by 2%. How much interest would the Japanese government have to pay on its government bonds for Americans to buy them?

12.    “Either expansionary fiscal policy or a currency depreciation will increase domestic national income by decreasing the level of foreign output demanded.” Comment on this statement.

13.    “A perfect-foresight model predicts that expansionary monetary policy has no effect on the level of output.” Comment on this statement with the help of an AD-AS diagram.

14.    When the federal government runs a budget surplus rather than a deficit, how will the public’s bond holdings and the supply of money be affected?

15.    “The central bank can lower the budget deficit through open market purchases.” Comment on this statement. In your answer discuss whether money financing or debt financing is more inflationary.

Answer 1

1. Usually, short-term interest rates are lower than long-term rates, so the yield curve slopes upwards, reflecting higher yields for longer-term investments. This is known as a normal yield curve. When the spread between short-term and long-term interest rates lessens, the yield curve begins to flatten. A flat yield curve is often seen during the transition from a normal yield curve to an inverted one.

2. When the government borrows from the public, the public gives the government money in exchange for bonds. If the government spends this money right away on programs, money supply is not affected. This is a fiscal policy measure and does not involve the Fed. Again if there is a fiscal deficit (G declines), it causes a decline in output (as Y= C+I+G+NX). Shifting IS curve to left-down, reducing interest rate and creating a contraction in the economy (short run equilibrium). However, money market might react, as lowering interest rate might influence a smaller return on the interest bearing assets, hence as real money demand/liquity preference of money is expressed as(M/P=L(Y, r)), correlated negatively with respect to r, it might increase money demand and money supply.

3. Yes, it creates a burden on future generations.

Due to issuing of new securities, interest rates will rise because of the increase in demand for loanable funds. So, the investment falls and economy grows less rapidly. Also, due to increase in interest rates, demand for the national currency rises, driving up the relative price of net exports and increasing trade deficit.

4.In the late 90s, the Federal National Mortgage Association started to make home loans accessible to borrowers with a lower credit score. It wanted everyone to attain the American dream of homeownership, regardless of credit. Lenders who extended home loans to high-risk borrowers offered mortgagez with unconventional terms. The easy lending standards fueled the housing growth and corresponding rise in home values. People with bad credit and little-to-no savings were offered loans they could not afford. Meanwhile, banks were repackaging these mortgages and selling them to investors on the secondary market.While housing prices continued to increase, the rising subprime mortgage market thrived. As the housevalues rose so quickly, the increase in home equity offset the bad debt buildup. If a borrower defaulted, banks could foreclose without taking a loss on the sale. The resulting seller’s market meant that if homeowners couldn’t afford the payments, they could sell the house and the equity would cover the loss.

A crisis was virtually inevtiable. Once the housing market slowed down in 2007, the housing bubble burst.